In our experience, a lawyer specializing in insurance coverage—even a whole group of insurance coverage lawyers—can practice for decades hearing the word "captive" thrown about by brokers or risk managers in large companies without being asked to address legal issues relating to a captive and without understanding what the heck a captive is or how it works. The National Association of Insurance Commissioners ("NAIC") and the Center for Insurance Policy Research define a captive as "an insurance company created and wholly owned by one or more non-insurance companies to insure the risks of its owner (or owners)."1 So at its core, a "pure" captive is a quasi-insurance company set up and funded by a business to serve as a form of self-insurance.
Captive Facts and Figures
While captives have been in existence in some form for 100 years, the use of captives has exploded in the last thirty-five years. According to A.M. Best, there are approximately 6,000 captives globally, up from 1,000 in 1980. The businesses who take advantage of this form of risk retention range from huge multi-national corporations (most Fortune 500 companies use captive subsidiaries) to small businesses in highly regulated industries (e.g., trucking) to sophisticated non-profits (e.g., hospitals). The formality, complexity, and size of captives ranges similarly. For instance, of the 6,000 captives currently operating, A.M. Best rates 200 of them. A.M. Best explains why a captive would want its rating services:
Although a rating on a captive is comparable to any other rating issued by A.M. Best, we recognize that captives serve special purposes and typically have an operating style that differs from the conventional market. A rating can be of benefit to a captive by demonstrating its financial strength and its best practice performance to a variety of stakeholders, such as fronting insurers, reinsurers, and a parent not otherwise engaged in insurance.2
In a parallel regulatory regime to conventional insurance companies, the organizing entity of a captive insurer must "domicile" the captive in a particular jurisdiction. Few jurisdictions, however, provide for captive-domiciled insurers, although that number is growing. The most popular domiciles for captives are Bermuda, the Cayman Islands, Guernsey, Luxemburg, Ireland, and Vermont (who would have thought?). Each of these domiciles provides a statutory regulatory structure which imposes greater or lesser requirements of reporting, capital, and reserves. For example, Vermont's insurance statutes contain a lengthy section devoted to the establishment and regulation of captives. See 8 VSA § 6001, et seq. Along with the regulatory regimes, an industry of lawyers, accountants, and actuaries has grown up to provide the services necessary to support captive insurers.
Why Form A Captive?
So why would a business with no experience in the insurance industry go to the time and expense to set up a captive insurance company in the Cayman Islands (sounds good for winter board meetings) or Vermont (sounds good for winter or summer board meetings) to cover its risks? The answer to this question differs depending on whether a company considers the use of a captive as an alternative to real self-insurance or as an alternative to purchasing a conventional insurance policy.
As an alternative to real self-insurance where a business simply absorbs and pays out of income all of its losses, a captive offers financial and administrative benefits. First, the premiums paid to a captive insurer that serve as the reserve fund for the payment of losses are tax deductible. This is not the case for losses paid directly by the business, even if the business has set up a separate reserve fund. Second, if a business faces a significant volume of claims, the establishment of a captive can reduce balance sheet uncertainty by providing historical claims and loss data, and can professionalize the approach to claims handling and reserve setting.
As an alternative to commercial insurance, a captive offers both significant advantages and some notable disadvantages. Based on the perceived riskiness of their industry, or a history of significant claims or other perceived blots on their record, some business are simply unable to purchase needed insurance at a reasonable price—or at all. Commercial insurance also sometimes includes exclusions or coverage language that does not match the risks of the business and is accordingly not worth the premium. Formation of a captive can take the place of commercial insurance, or can provide a primary layer of insurance that makes it more palatable for commercial insurers to sell excess above the captive layer. Running insurance through a captive using a reputable actuary to make projections for several years provides historical claims and loss payment information and reserving data that may eventually lead to commercial insurers taking on the risk. Depending on the type of business, a captive primary level, or a captive reinsuring a commercial fronting insurer, can save significant money. In an insurance tower, primary insurance is typically the most expensive. A well-run captive can reduce the primary layer cost by eliminating the commercial insurer profit margin and risk premium and layers of overhead. (Some estimate the savings at 15-30 percent).
All those advantages do not come without disadvantages. For instance, some business entities are simply not equipped to establish and run an insurance company, no matter whether it is minimally regulated or heavily regulated. To do the job properly, the business must hire experienced claims administrators to take in and evaluate claims, assign claims handlers or hire outside counsel, supervise outside counsel, work with actuaries to set appropriate claim reserves, work with accountants to properly administer the books and records of the captive, set up a formal governance structure with a board and annual meeting in the domicile, and interact with the regulators. In a huge corporation with many claims, the captive administration is a big business. Because large corporations have insurance towers in every segment of their risks (D&O, E&O, cyber/IT, EBL, fiduciary, etc.), the captive insurer is the primary claims administrator and its handling of claims may affect the interests of the excess insurers. Once a large claim hits that may call on excess insurance, excess insurers will undoubtedly flyspeck the work of the captive and even deny claims based on alleged negligence or intentional misconduct by the captive which typically might include faulty notice and under-reserving. Regulators may claim that a captive has over-reserved, a practice that shelters more income of the sponsoring entity from taxation.
Captives Come in Different Flavors
As stated above, the "pure" captive insures only the risks of the parent, sponsoring company or owner. There are also "group" or "association" captives that are formed by unrelated groups of entities for the purpose of insuring the group against similar risks. There are also "rent-a-captive" arrangements where a company may sponsor a captive and then "rent" out the capital of the captive to other businesses who then maintain an account within the captive, but do not have the burden of maintaining and administering the captive's insurance functions. There are "protected cell" or "segregated cell" captives which provide for separate accounts within the captive for different business entities where the capital of each cell is not exposed to the liability risk of the other cells. Each of these captive types carries its own advantages and disadvantages, greater or lesser administrative burdens and higher or lower expenses.3
So what's not to like about captives? They can cost less, cover more, and provide for much greater control by the sponsoring companies in the handling of claims. But the advantages come with complexity, statutory regulation, the need to engage professionals, and the imperative of scrupulous oversight.
1 "Captive Insurance Companies," http://.naic.org/cipr_topics/topic_captives.htm (Updated 3/28/2016).
2 AM Best Captive Update, News of Alternative Risk Markets From A.M. Best Company, January, 2016.
3 While the subject of captive insurance – like actuarial science – seldom appears on the top ten most exciting insurance topics, the most current "hot topic" in captives relates to the establishment of captives by insurance companies to finance a particular type of reserves in the universal life context. In some circumstances, understood only by those steeped in the topic, these reserves are considered excessive or redundant statutory reserves. Insurance companies set up captives to fund these redundant reserves and can use assets to capitalize the captive that would not permitted reserves on their own books (non-admitted assets).
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